Make the Beneficiary IRA Rules Work for You

If you are in a position to inherit an IRA from someone who has passed away, you need to know there are specific rules governing these accounts. You could end up paying a fortune in taxes if you do not know the beneficiary IRA rules. For instance, if you are the spouse of the IRA owner, you have different rules than if you are a non-spouse beneficiary.

It might be a difficult time for you right now, but you have to make sure you understand how your loved one’s IRA funds are going to be handled so that you can get the most money possible in the exchange. Some of the beneficiary IRA rules are standard across the board, regardless of which type of IRA you are inheriting. Other rules are specific to the kind of IRA your loved one had. If you have any questions about the type of IRA you have, consult an investment specialist to look over the account.

General Beneficiary IRA Rules:

IRA beneficiaries can be estates, dependents (including spouses and children) and any other person the owner wishes to receive the funds in an IRA upon his or her death. To designate a beneficiary, the owner of the IRA will need to contact the fund’s management company and notify it of the designation (just like with your other retirement savings accounts). You can usually download a beneficiary form on the company’s website and some even allow you to add or change a beneficiary directly through your online account.

To inherit a Traditional IRA, you must be named as a beneficiary on the account before the owner passes away. If there is more than one beneficiary named on the account, the person who has the shortest life expectancy will become the designated beneficiary as long as:

All beneficiaries are individuals, and

The IRA account was not divided into separate shares for each beneficiary

Most of the time, an account holder names his or her spouse and children as beneficiaries. If the spouse is not designated the primary beneficiary and the children secondary, then this rule would apply and the spouse would receive the funds because he or she would have the shortest life expectancy.

The beneficiaries of an inherited IRA are required by the IRS to include any distributions they receive from a Traditional, SEP or SIMPLE IRA.

Rules for an IRA Inherited from a Spouse:

In most cases, if you inherit a Traditional IRA from your spouse after his or her death, you will be able to roll the funds over into another Traditional IRA that has been established in your name. Your other option is to simply treat the beneficiary IRA as your own rather than rolling it over into a new account. The IRS will make the choice to name you as the account owner instead of rolling it over if:

You are the sole beneficiary of the inherited IRA

You have an unlimited right to withdraw the funds in it

You make contributions to the inherited IRA, or

You do not make the required distributions from the IRA

In the event that you withdraw any of the funds in the IRA, even if you roll over the balance, you will have to pay taxes on the portion you withdraw. In addition, you will be subject to a 10 percent early withdrawal penalty if you are younger than 59 and a half. Of course, there are some exceptions to this rule:

If you withdraw funds from a beneficiary IRA that are then used for education purposes for you or your kids, you will not have to pay the early withdrawal penalty on the $10,000 maximum distribution. You do still have to pay taxes on this amount.

If you withdraw funds from an IRA that are then used to build, buy or rebuild a first home, you will not be subject to the early withdrawal penalty on the $10,000 maximum distribution. You will still pay taxes on this amount.

As the spouse of the account holder, you will be required to begin taking distributions from your account by April 1 of the year after you turn 70 and a half years old. You have to withdraw the minimum distribution by December 1 of that year. If you do not take the minimum distribution amount by that date, you will likely have to pay a 50 percent excise tax on the amount that you did not take.

If you inherited an IRA before your spouse began receiving distributions, you will be named the owner of the IRA. If your spouse already started receiving distributions before his or her death, you can claim an estate tax deduction on any portion of a distribution that was “income in respect of a decedent.”

Rules for an Inherited IRA from Someone Other than a Spouse:

If you inherit a Traditional IRA from someone who was not your spouse, (i.e. your parent), you are not able to treat it as your own IRA. In addition, you are not eligible to roll over any portion of the IRA into your own account and you cannot make new contributions to the beneficiary IRA. However, as with the original owner, you will not have to pay taxes on any funds in the IRA until you begin receiving distributions.

In the event that the IRA owner passed away before taking any distributions, then these rules will apply to non-spouse beneficiaries:

All funds in the IRA must be distributed:

By December 31 of the fifth year following the account owner’s death, or

Over the life of the beneficiary or over a period that does not extend beyond the beneficiary’s life expectancy.

As the beneficiary, you can choose which distribution rule you want to apply to your account. You will usually have to make your choice by December 31 of the year following the death of the original owner. If you choose the second rule, you will be required to begin your distributions by December 31 of the year following the death of the owner.

Since these rules require you begin taking distributions, you will not incur an early withdrawal penalty even if you are not yet 59 and a half years old. You will, however, be required to pay taxes on all distributions.

IRA vs 401k Central is for entertainment and reference purposes only. The information presented is the opinion of the author only and should not be interpreted as specific advice or recommendations towards your financial situation. Always consult with a true professional before making any financial decisions.

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